Carried Interests – Are They Subject to Ordinary Income Tax Rates or to Capital Gain Rates?
Many builders, partners, syndicators, managers, and others involved in bringing together a group of investors, whether that group is under an entity that is a limited partnership (LP), general partnership (GP), limited liability Company (LLC), or other pass through entity, have been concerned with the treatment of the promotional interest/capital share or other incentive that is to be paid to the promoter of the entity that is investing in real estate.
For purpose of this discussion, we might refer to the individual(s) that is bringing together the investment group as the Syndicator or the Promoter.
To illustrate the point of this Tip involving “carried interests,” assume a Syndicator, S, brings together investors to buy interests in an LLC that S formed to acquire an apartment building or other real estate investment. As part of the consideration to be paid to S for the efforts by S, S receives a given percentage interest in the LLC. S might also invests capital/cash in the LLC; however, in addition to such purchase by S in the LLC entity, S is being paid say a 20% interest in all payouts to the investors, payable only after all the investors have received a full return of their investment. This return may or may not also include a given priority payment to the investors of say 8% interest on their investment, prior to other payouts to the investors and S.
Because of various tax laws that have existed, along with case law, many syndicators have treated the promotional or incentive interest under two very important tax positions:
1. The promotional interest would not be taxed at the formation of the entity; and
2. The promotional interest, if ultimately paid to the S, would be taxed at the tax rate applicable to long term capital gains and not as ordinary income.
There has been opposition to this treatment. The IRS had taken the position that the amounts should be currently taxed; and, such amounts were payments for services and thus should generate ordinary income, not long term capital gain treatment.
To emphasize these points based on the example given above, the S’s position was that the tax payable on the incentive interest, the 20% interest noted above, would be taxed only when and if the S actually received any payment of the incentive interest. Thus, it would not be taxed currently, when the entity was formed.
Further, the S would pay tax on such incentive payments by paying tax as computed on long term capital gain, not ordinary income.
Once again, the IRS opposed these two positions. Congress supported this concern and treatment by the IRS. Congress passed Section 83 of the Internal Revenue Code to tax the incentive payment in some circumstances. Under this rule, Section 83 (a) stated:
“(a) General rule. --If, in connection with the performance of services, property is transferred to any person other than the person for whom such services are performed, the excess of--
(1) the fair market value of such property (determined without regard to any restriction other than a restriction which by its terms will never lapse) at the first time the rights of the person having the beneficial interest in such property are transferable or are not subject to a substantial risk of forfeiture, whichever occurs earlier, over
(2) the amount (if any) paid for such property,
shall be included in the gross income of the person who performed such services in the first taxable year in which the rights of the person having the beneficial interest in such property are transferable or are not subject to a substantial risk of forfeiture, whichever is applicable. ….”
What this means is that S would have taxable ordinary income, currently, unless S could show that the promotional interest, the 20% in the example, is not transferable and is subject to being forfeited.
(There is much more to say about this rule under Section 83 and the applicable Regulations. However, the essence for this discussion is quoted, above. For more on this issue, see Levine, Mark Lee and Segev, Libbi Levine, Real Estate Transactions, Tax Planning, Thomson, Reuters, West (2021).)
Further as to this issue of the payment of taxes on a promotional interest held by S, Congress passed Code Section 1061. This Section imposes a further concern for the S as to the promotional interest received. It states:
“(a) In general-- that if one or more applicable partnership interests are held by a taxpayer at any time during the taxable year, the excess (if any) of--
(1) the taxpayer’s net long-term capital gain with respect to such interests for such taxable year, over
(2) the taxpayer’s net long-term capital gain with respect to such interests for such taxable year computed by applying paragraphs (3) and (4) of section 1222 by substituting “3 years” for “1 year,” (emphasis supplied) shall be treated as short-term capital gain, notwithstanding section 83 or any election in effect under section 83(b).”
Thus, the S must hold the promotional interest in excess of 3 years to possibly be able to treat the gain from this interest as long term capital gain.
To further support and interpret the rules under Code Section 1061, the Department of the Treasury issued Final Regulations in January 2021. (These were issued under 26 CFR Part 1[TD 9945]RIN 1545-BO81.)
The Regulations summarized their position by stating:
“This document contains final regulations that provide guidance under section 1061 of the Internal Revenue Code (Code). Section 1061 re characterizes certain net long-term capital gains of a partner that holds one or more applicable partnership interests as short-term capital gains. An applicable partnership interest is an interest in a partnership that is transferred to or held by a taxpayer, directly or indirectly, in connection with the performance of substantial services by the taxpayer, or any other related person, in any applicable trade or business. These final regulations also amend existing regulations on holding periods to clarify the holding period of a partner’s interest in a partnership that includes in whole or in part an applicable partnership interest and/or a profits interest. These regulations affect taxpayers who directly or indirectly hold applicable partnership interests in partnerships and the pass-through entities through which the applicable partnership interest is held.”
Thus, the Regulations make it clear that a gain that might arguably be treated as long term capital gain will be treated as short term capital gain, if the holding period is not greater than 3 years. This applies to “applicable partnership interests” (API), but it also applies to most pass through entities, as further stated in the Regulations. There are many other issues covered by these new Final Regulations and there are exceptions to the above rules. However, the essence, for purposes of this Tip as to a promotional interest, are described above.
Such position under the Code and Regulations may certainly encourage promoters of investment interests in real estate to consider the impact of the holding period of the investment in question, if one objective of the promoter/S is to generate long term capital gain as to the promotional interest held.
Dr. Mark Lee Levine,
Professor, University of Denver